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Prospect Theory

Updated on May 28, 2024
Article byPrakhar Gajendrakar
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Prospect Theory?

Prospect theory refers to the theory explaining people’s choices influenced by biases like loss aversion. People are more loss averse than profit devoted. In simple terms, it indicates a preference for less risky or profits certain options compared to the options containing losses.

It’s a Nobel prize-winning work explaining people’s decision-making process under complex and uncertain situations. People analyze the situations and think in terms of gains and losses. It reflects the influence of emotions and attitudes more intense than the logical and rational thinking in the decisions produced. People of any age, gender, or culture can exhibit behavior explained by the theory.

Key Takeaways

  • Prospect theory in psychology suggests that people will think about gains and losses and prioritize the potential value of losses and gains rather than the potential outcome while choosing from alternatives.
  • It is also known as loss aversion theory because it points out that the fear of loss is greater than the satisfaction from profit.
  • The three main biases influencing the decision-making explained by the theory are a certainty, loss aversion, and isolation effect.

Prospect Theory Explained

“Prospect Theory: An Analysis of Decision under Risk,” the journal article by Daniel Kahneman and Amos Tversky, presented the concept in 1979 as an alternative model to expected utility theory. The theory explains the irrational human behavior influenced by various biases like risk-averse and risk-seeking behaviors. For example, people are likely to choose a more secure option than take a high-risk option with high-profit potential when the outcome is unknown. In contrast, expected utility theory explains the rational choice made by selecting the option with the highest expected utility.

The prospect theory in psychology explains biases influencing the decisions of individuals. The main three biases are a certainty, isolation effect, and loss aversion.

Prospect Theory and Biases

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Certainty

Prospect theory has two certainties: certainty of gain and loss. First, it postulates that when given a choice between an assured profit and a greater profit but with a risk factor, people will go with the first one avoiding any form of risk at all. In contrast, people also take greater risks to prevent the certainty of loss.

Isolation Effect

It is also known as the Von Restroff Effect and was introduced by German psychiatrist and pediatrician Hedwig von Restorff. It is the behavior of people who tend to point out differences than similarities between the given choices. While comparing alternatives, people tend to give more importance to the differences than common factors in making decisions. Hence it is included in the explanation of prospect theory.

Loss Aversion

A critical aspect of individual behavior states that everyone has a certain fear of loss, which is always bigger than the joy of winning. In other words, when given a chance, people will tend to minimize their losses than maximize gains, and they remember loss more significantly than a profit. It is a type of survival mechanism.

Examples

  • There are two options for Anna. The first option has a 100% probability of gaining $1000 and the second option presents a 50% chance of gaining $2000. Therefore, according to the theory, Anna will become risk-averse and chooses the safe option presenting a certain gain of $1000. she forgoes the second option that has the potential to produce double the return because there is a 50% chance of losing by selecting the second option.
  • To avoid the pain of incurring loss at certain times, investors decide not to sell stocks in a downtrend. Instead, they willingly remain in a risky stock position, hoping for a trend reversal exhibiting an uptrend. 
  • There are two options: one with a 100% chance of incurring a loss and the second with an equal chance to obtain gain or loss. Both cases contain loss elements and one with a certain loss. In this case, both options may lead to a loss, and choosing the second option present a 50% chance of making a gain hence the individual making the decision can become risk-seeking to avoid losses. 

How to Overcome?

  • Compare the options rationally; the options may be equal, but their portrayal can make them look different; hence people should scrutinize all options giving them equal importance.
  • In the field of investing, investors can overcome the influence of biases by understanding biases, being aware of biases, studying past trends using historical data, and exercising cognitive control.
  • Before making any decision, ensure the combination of subjective and objective data as input in the decision-making process.

Frequently Asked Questions (FAQs)

What is the prospect theory definition?

It is a theory of behavioral economics developed by psychiatrists Daniel Kahneman and Amos Tversky. The theory explains the phenomenon of individuals prioritizing the potential value of losses and gains rather than the potential outcome while choosing from alternatives.

What is a prospect theory example?

One of the examples is investors holding onto a stock even if the price is falling because they don’t want to obtain loss by selling falling stocks and refrain from selling the stocks. Another example is picking an alternative that assures a 100% chance of gaining a minimum profit than an alternative that presents a 50% chance of extraordinary gain.

What are the three key features of prospect theory?

The three main biases influencing the human behavior and decision, according to the theory, are:

– Certainty: Choosing option with certainty
– Isolation effect: Prioritize the differences between the possibilities than similar information
– Loss aversion: Prioritize avoiding possible losses than being gain seeking

This article has been a Guide to What is Prospect Theory. We explain prospect theory-an analysis of decisions under risk, the definition in psychology, examples, etc. You can learn more from the following articles –